The Importance of a Buy-Sell Agreement

April 30, 2018
By
Brown & Vogel, LLC

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When you’re starting a new business venture with new partners, you
tend to think about financial contributions, roles that each partner will
play, and how you will work together to make the business succeed. You’re
usually not thinking about the eventual end of the business because you
figure you’ll have 20 years or so to worry about that later. But
we encourage you to begin with the end in mind, and make a buy-sell agreement
part of your start-up documents!

A Buy-Sell Agreement is a written agreement among the owners of a business
in which each owner agrees that upon the occurrence of a specified event
(death, disability, termination of employment, etc.), his or her shares
will be sold to the surviving owners at a specific price, and each owner
commits to buy the shares of their departing co-owner when that time comes.

There are several reasons a good buy-sell agreement is important to you:

A valid buy-sell agreement will protect you and your family.

If you retire or become disabled, your chosen successors will buy your
interest at fair market value.

If you die while owning the business, a buy-sell agreement can guarantee
a buyer and a predetermined price for your heirs.

A buy-sell agreement negotiated between you and an unrelated successor
provides a valuation that you can generally rely on for gift and estate
tax purposes.

Buy-Sell Agreements can be funded (usually with life insurance) or unfunded
(usually with promises to pay). Funding a Buy-Sell Agreement with life
insurance is usually the most practical method – the heirs get cash
and walk away, and the surviving owner gets the deceased owner’s
shares immediately. Unfunded Buy-Sell Agreements are usually better than
no agreement, but the odds of the heirs ever getting paid are relatively
low. Quite often the earnings are not sufficient to pay off the heirs.

There are generally three different types of buy-sell agreements:

Cross-Purchase Agreement: A cross-purchase agreement allows the remaining co-owners to purchase
the interest of a departing owner. Each co-owner must have sufficient
capital tomake the purchase. For the death of an owner, each owner generally
acquires a life insurance policy on the lives of each other owner, and
the death benefits received are required to be used to purchase the deceased
owner’s interest.

Entity (or Redemption) Purchase Agreement: An entity purchase agreement requires the business to purchase the interest
of a departing owner. After the purchase, the remaining owners would be
the only owners of the entity. It is also common to fund the purchase
with a life insurance policy purchased by the business.

Hybrid Agreement: A hybrid agreement provides the remaining owners and the business itself
to purchase the interest of a departing owner. With a hybrid agreement,
it is possible to give the individual owners the right to acquire the
interest, but not the obligation. If the owners decline, the business
would be obligated to acquire the interest of the departing owner. Alternatively,
the agreement may allow for both the remaining owners and the company
to purchase the departing owner’s interest. Therefore the hybrid
agreement has characteristics of both the cross-purchase and the entity-redemption
agreement and is the most flexible.

The valuation section of a buy-sell agreement is very important because
it defines how the value of the owner’s interest will be valued
when there is a change in ownership. The method of valuation must be clearly
defined. A method should be selected that determines current fair market
value at the time of the triggering event. Vague language for a formula
that establishes a range of prices, rather than a firm price should be
avoided. The reason is that two valuation professionals using vague language
may calculate two very different values, either of which is within the range.

In a company with two or more major shareholders, a cross-purchase buy-sell
agreement will generally be among the co-owners. The same is true in a
professional practice with multiple principals or partners. If the buy-sell
agreement is an entity-redemption agreement or a hybrid agreement, the
agreement will be between the owners and the entity (company).

If a company has only one owner, it’s up to that owner to find a
successor and enter into a buy-sell agreement. Sometimes the successor
will come from the next generation of the family.

When there is no related heir apparent and no co-owners, finding a successor
can be difficult. A key employee might be designated. Or the owner of
a successful medium-sized company or professional practice might actually
acquire a smaller firm headed by a younger individual, in the hope that
the prime mover behind the acquired entity will someday take over the
larger firm. In any event, a buy-sell agreement should be in place between
the current owner and the designated successor.

Life insurance is frequently used to fund a buy-sell agreement. That is,
the insurance proceeds provide the buyer with the necessary cash to carry
out the agreement.

A buyout agreement may require surviving owners or successors to pay a
lump sum or periodic installments when a triggering event occurs. The
choice of payment will often vary, depending on the nature of the triggering
event. Buyouts that require a lump sum payment are likely to be funded
with life insurance or lump sum disability insurance, if it can be obtained.

Under an entity-redemption agreement, the company buys and is the beneficiary
of an insurance policy on the life of each business owner. Each policy
is for the amount needed to buy that owner’s interest. In a reciprocal
cross-purchase agreement, each party buys and is the beneficiary of a
policy on the life of each of the other owners for the amount that is
their pro-rata share of the buyout price.

Assume a hypothetical $1 million business with two equal owners. With an
entity-redemption buyout agreement the company will buy, and be the beneficiary
of, a $500,000 policy on each owner’s life. In a cross-purchase
plan, each owner will own and be the beneficiary of a $500,000 policy
on the other owner’s life. Obviously, the cross-purchase plan becomes
more complicated as the number of owners is increased.

The information on this website is for general information purposes only.
Nothing on this site should be taken as legal advice for any individual
case or situation. This information is not intended to create, and receipt
or viewing does not constitute, an attorney-client relationship.